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Dynamic Trading with Predictable Returns and Transaction Costs

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Author Info
Nicolae B. Garleanu
Lasse H. Pedersen

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Abstract

This paper derives in closed form the optimal dynamic portfolio policy when trading is costly and security returns are predictable by signals with different mean-reversion speeds. The optimal updated portfolio is a linear combination of the existing portfolio, the optimal portfolio absent trading costs, and the optimal portfolio based on future expected returns and transaction costs. Predictors with slower mean reversion (alpha decay) get more weight since they lead to a favorable positioning both now and in the future. We implement the optimal policy for commodity futures and show that the resulting portfolio has superior returns net of trading costs relative to more naive benchmarks. Finally, we derive natural equilibrium implications, including that demand shocks with faster mean reversion command a higher return premium.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 15205.

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Date of creation: Aug 2009
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Handle: RePEc:nbr:nberwo:15205

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Find related papers by JEL classification:
G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing

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  1. Hong Liu, 2004. "Optimal Consumption and Investment with Transaction Costs and Multiple Risky Assets," Journal of Finance, American Finance Association, vol. 59(1), pages 289-338, 02. [Downloadable!] (restricted)
  2. Markus K. Brunnermeier & Lasse Heje Pedersen, 2005. "Predatory Trading," Journal of Finance, American Finance Association, vol. 60(4), pages 1825-1863, 08. [Downloadable!] (restricted)
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  3. Heaton, John & Lucas, Deborah J, 1996. "Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing," Journal of Political Economy, University of Chicago Press, vol. 104(3), pages 443-87, June. [Downloadable!] (restricted)
    Other versions:
  4. Balduzzi, Pierluigi & Lynch, Anthony W., 1999. "Transaction costs and predictability: some utility cost calculations," Journal of Financial Economics, Elsevier, vol. 52(1), pages 47-78, April. [Downloadable!] (restricted)
  5. Andrew W. Lo & Harry Mamaysky & Jiang Wang, 2004. "Asset Prices and Trading Volume under Fixed Transactions Costs," Journal of Political Economy, University of Chicago Press, vol. 112(5), pages 1054-1090, October.
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  6. Anthony W. Lynch & Pierluigi Balduzzi, 2000. "Predictability and Transaction Costs: The Impact on Rebalancing Rules and Behavior," Journal of Finance, American Finance Association, vol. 55(5), pages 2285-2309, October. [Downloadable!] (restricted)
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  7. Acharya, Viral V. & Pedersen, Lasse Heje, 2005. "Asset pricing with liquidity risk," Journal of Financial Economics, Elsevier, vol. 77(2), pages 375-410, August. [Downloadable!] (restricted)
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  8. Longstaff, Francis A, 2001. "Optimal Portfolio Choice and the Valuation of Illiquid Securities," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 14(2), pages 407-31.
  9. Bong-Gyu Jang & Hyeng Keun Koo & Hong Liu & Mark Loewenstein, 2007. "Liquidity Premia and Transaction Costs," Journal of Finance, American Finance Association, vol. 62(5), pages 2329-2366, October. [Downloadable!] (restricted)
  10. Vayanos, Dimitri, 1998. "Transaction Costs and Asset Prices: A Dynamic Equilibrium Model," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 11(1), pages 1-58.
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